During this time, lenders pooled the subprime mortgages into MBS and CDOs. These financial products often received high ratings from credit agencies. Tranches of these securities were then sold to unsuspecting investors, who were not aware of the risk associated with them. The lower-quality tranches offered higher interest rates but absorbed the first losses associated with defaulting mortgages before the senior tranches.

Subprime lending caused a dramatic increase in available mortgage credit. Many loans were made to borrowers who would have previously had difficulty obtaining mortgages due to below-average credit scores. Private lenders made a lot of money by pooling and selling the subprime mortgages. However, the risk of foreclosure increased with the relaxing of credit standards. Lenders and buyers incorrectly assumed that real estate values were impervious to a downturn. Private-label MBS provided a lot of the necessary capital for the subprime mortgages. Around 80% of subprime loans were made with private-label MBS in 2006. In March 2007, the value of subprime mortgages was valued at around $1.3 trillion. The mortgages issued by private lenders had greater risk since they were not backed by the government, like those from Freddie Mac and Fannie Mae.

The real estate market boomed, with more buyers bidding up the prices of available houses. The real estate markets in Florida, Arizona and the Las Vegas area were very hot during this time. At first, subprime borrowers who fell behind could refinance their mortgages based on higher property values or could sell homes at a profit. The amount of risk for subprime mortgages was not an issue at this time.

Only when property values began to decline did issues begin to appear. Adjustable-rate mortgages began to reset at higher rates, and mortgage delinquencies grew substantially. The default on subprime mortgages led to more problems. By August 2008, around 9% of all mortgages in the U.S. were in default. MBS and CDOs began to lose value with the higher default rates. Freddie Mac and Fannie Mae were seized by the government in 2008 as they began to realize large losses. Foreclosures and repossessions increased, with more properties being placed on the market as banks attempted to liquidate their inventories. This depressed property values even more, leading to a downward spiral for the real estate market. Some borrowers attempted short sales for their underwater mortgages, but they often found lenders difficult to work with or unwilling to negotiate.

Advisor Insight

I could write a book on this topic because I worked in the business for many years and I had the big short on myself at a hedge fund I worked at during the financial crisis.

Securitization is the packaging of loans or leases and has been around since the 1980s. Securitization really took off in the 1990s and exploded in the 2000s in terms of issuance volume. Used wisely, its a very effective form of financing for underwriters of loans and leases (auto, mortgage, credit cards, etc.).

The securitizations owned the subprime mortgage loans that eventually defaulted and caused a banking crisis. The number of loans originated in the 2000-2006 period was unusually large because we had a real estate bubble in the United States. The banks that held these securitizations as investments lost tens of billions of dollars which almost caused the US banking system to collapse. The bailout money provided by the US government preserved the banking system that we have today.

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In securitization, an issuer designs a marketable financial instrument by merging various financial assets into one pool and then selling the repackaged assets to investors. It most often occurs with loans and other assets that generate receivables—different types of consumer or commercial debt.